Author
Topic: Knock out PMI vs alternatives (Read 658 times)

Hey all,I have a question that I can't answer and part of it is I need help framing PMI in order to evaluate opportunity costs.I have a mortgage of 189,000. I put 10% down, so the sale price is 210,000. The property was appraised at 218,000 and expected to increase by 5% over the next year (years of 10% appreciation have slowed as folks get priced out). In this locale the way folks have gotten out of PMI is mainly through reappraisal/appreciation. Of course that carries the costs associated with refinancing. Perhaps we can ignore the option of refinancing because the costs of PMI in my case are low?

The interest rate on the mortgage is 4.75%. The PMI is $35/mo. I *think* of PMI as like having an extra 0.3% added to the interest rate over the duration PMI is applied (not over the 30 yr duration).

Some additional facts:1) Assuming 2% (or 5%) appreciation annually, it would take ~4 years (or 2.3 yr) for PMI to be dropped via reappraisal.2) It would take 6.3 years for PMI to be dropped based on LTV. -Based on 1 and 2, the breakeven point for a refi using appreciation would make the first fact moot, correct?3) Dumping in an extra $100 (or $200) to principal would accelerate the schedule such that PMI would be dropped at 3.5 yr (or 2.6 yr)

So the question is: the option of 100 or 200 added monthly versus investment (taxable or there is room for pre-tax). The place is outdated and I could also do home improvements with the cash..My gut tells me to choose investing but I need help deriving the tradeoffs quantitatively.

[edited a few numbers] Also, I know the PMI is so low that it could easily be mitigated by making better daily consumption choices. It just irks me that I can't wrap my head around it.

The true costs of PMI are often underestimated due to the deceptive nature of the math. The ~0.22% is being charged over the full loan amount, however it only applies to the funds above the PMI reappraisal amount, so in reality it is effectively about ten times this amount. (In your case, your $420 per year is being paid for the extra $21,000 you borrowed, meaning you're starting out at 2% and increasing the percent as the loan is paid off until PMI can drop off.)

All of that being said, my general advice is once you have PMI, stick with it. Paying it off faster is suboptimal due to opportunity costs (assuming you have a long time horizon until retirement). Invest all remaining money in low-cost tax deferred index fund assets.

If my maths are right...An extra $100 a month would shave off 2.8 years. That would save me $1176 in PMI. If I invested that at 6% over 2.8 yr, it would compound to $4957 for a return of $1597. An extra $200 a month would shave off 3.7 years. That would save me $1554 in PMI. If I invested that at 6% over 3.7 yr, it would compound to $13179 for a return of $3721. The assumption is this amount would be invested for decade(s) and not be cashed out at the end of the duration so we can ignore volatility risk.

edit: Hell I did the math with current bank and CD rates; the comparison is so close that it is worth keeping the cash more liquid.

There is no guarantee prices will go up at 5 percent a year or that a random appraisal will give you the number you need. Before I did anything, I would read through the loan documents and confirm with the loan servicer what the process is to get PMI removed. Not all loans are the same. Once you do that, you will know what you need to do.

You do not have to pay the costs of refinancing to get PMI canceled in most cases. You will likely have to pay for an appraisal. Whether you should refinance at a given point depends on interest rates and the costs of the new loan. In two years, the market interest rate could be in the mid 5's or in the mid 3's. You would probably refinance if you can get a loan in the mid 3's and pay down to 80 percent if rates are in the mid 5's.

You can't quantify the choices because the future is unknown. In your shoes, I would probably invest and wait it out.

Depending on your market, if your house really is outdated and you have mad DIY skills, you could make judicious improvements, then look for a no-cost re-fi. Depending on the appraisal, you might get the LTV you need (80%). If you're close, it might be worth throwing a grand or three in at closing to make the numbers work. Current mortgage rates are at least as good as what you have now.

Otherwise, I agree with Boof. PMI was a tool that got you into your house with less than 20% down. Consider being grateful that it exists, while you patiently figure out how to get rid of it.

Thanks for the clarification re: refi vs just appraising to adjust the LTV. I know an appraisal doesn't mean squat until its acted upon, though its better than sticking my finger in the air. Nor is appreciation a given, that's why I was modeling it as a variable. I'll double check my documents. My appraisal would cost about 1.5x years of PMI so that's significant.

I think the answer has made itself obvious (invest over adding more to principal, wait and see if a reappraisal makes sense over the next few years) but I would welcome other perspectives.Slow, live-in reno is already part of the budget so that can only help.

If my maths are right...An extra $100 a month would shave off 2.8 years. That would save me $1176 in PMI. If I invested that at 6% over 2.8 yr, it would compound to $4957 for a return of $1597. An extra $200 a month would shave off 3.7 years. That would save me $1554 in PMI. If I invested that at 6% over 3.7 yr, it would compound to $13179 for a return of $3721. The assumption is this amount would be invested for decade(s) and not be cashed out at the end of the duration so we can ignore volatility risk.

edit: Hell I did the math with current bank and CD rates; the comparison is so close that it is worth keeping the cash more liquid.

It takes a while to learn all of the nuances in the math. Let's just say it is much more complicated than this. Here are some of the major points you miss:

1) You need to analyze this using time periods that will take you out to when you have relatively similar investment strategies. In the case of a 30-year mortgage, you'll want to run the simulation out for 30 years over the different investment scenarios.* (When you are early in your investment career, I wouldn't worry about volatility risk but instead use some fixed return like you did, though 6% is probably low if you're considering all equities.)

2) You should consider the bump to your bottom line that comes from tax-deferred assets. If you're in the 25% tax bracket (state and federal), you'll see a roughly 33% increase in funds off the bat using your 401k or Traditional IRA.

*You can run the math using spreadsheets and what-not if you like, or if you'd prefer (or are math-averse) you can take my word that I've run them. What they've revealed to me is that PMI is a generally bad bet if you can put 20% down (without restricting your tax-deferred investments), but if not you should not pay PMI down early due to opportunity cost. If you do decide to run them yourself, just make sure you run them out 30 years to get the full picture.

If my maths are right...An extra $100 a month would shave off 2.8 years. That would save me $1176 in PMI. If I invested that at 6% over 2.8 yr, it would compound to $4957 for a return of $1597. An extra $200 a month would shave off 3.7 years. That would save me $1554 in PMI. If I invested that at 6% over 3.7 yr, it would compound to $13179 for a return of $3721. The assumption is this amount would be invested for decade(s) and not be cashed out at the end of the duration so we can ignore volatility risk.

edit: Hell I did the math with current bank and CD rates; the comparison is so close that it is worth keeping the cash more liquid.

It takes a while to learn all of the nuances in the math. Let's just say it is much more complicated than this. Here are some of the major points you miss:

1) You need to analyze this using time periods that will take you out to when you have relatively similar investment strategies. In the case of a 30-year mortgage, you'll want to run the simulation out for 30 years over the different investment scenarios.* (When you are early in your investment career, I wouldn't worry about volatility risk but instead use some fixed return like you did, though 6% is probably low if you're considering all equities.)

2) You should consider the bump to your bottom line that comes from tax-deferred assets. If you're in the 25% tax bracket (state and federal), you'll see a roughly 33% increase in funds off the bat using your 401k or Traditional IRA.

*You can run the math using spreadsheets and what-not if you like, or if you'd prefer (or are math-averse) you can take my word that I've run them. What they've revealed to me is that PMI is a generally bad bet if you can put 20% down (without restricting your tax-deferred investments), but if not you should not pay PMI down early due to opportunity cost. If you do decide to run them yourself, just make sure you run them out 30 years to get the full picture.

Additional payments would cease after PMI is ended. I understand if the comparison is pay down mortgage or invest but this isn't the case. Why would I not use a fixed-term to calculate opportunity cost? At any rate it would look something like (a) Pay extra to mortgage until PMI is gone then invest in the market OR (b) invest in the market. Make comparison at 30 yr. This would favor the latter even more. [6% is a semi conservative real return that I use]And, in this scenario I am admittedly constraining the comparison to after-tax monies. Pre-tax would put the investment option over the top. But that is moot information regarding the decision making because even post-tax investments beat PMI (assuming you find my comparison adequate).

If my maths are right...An extra $100 a month would shave off 2.8 years. That would save me $1176 in PMI. If I invested that at 6% over 2.8 yr, it would compound to $4957 for a return of $1597. An extra $200 a month would shave off 3.7 years. That would save me $1554 in PMI. If I invested that at 6% over 3.7 yr, it would compound to $13179 for a return of $3721. The assumption is this amount would be invested for decade(s) and not be cashed out at the end of the duration so we can ignore volatility risk.

edit: Hell I did the math with current bank and CD rates; the comparison is so close that it is worth keeping the cash more liquid.

It takes a while to learn all of the nuances in the math. Let's just say it is much more complicated than this. Here are some of the major points you miss:

1) You need to analyze this using time periods that will take you out to when you have relatively similar investment strategies. In the case of a 30-year mortgage, you'll want to run the simulation out for 30 years over the different investment scenarios.* (When you are early in your investment career, I wouldn't worry about volatility risk but instead use some fixed return like you did, though 6% is probably low if you're considering all equities.)

2) You should consider the bump to your bottom line that comes from tax-deferred assets. If you're in the 25% tax bracket (state and federal), you'll see a roughly 33% increase in funds off the bat using your 401k or Traditional IRA.

*You can run the math using spreadsheets and what-not if you like, or if you'd prefer (or are math-averse) you can take my word that I've run them. What they've revealed to me is that PMI is a generally bad bet if you can put 20% down (without restricting your tax-deferred investments), but if not you should not pay PMI down early due to opportunity cost. If you do decide to run them yourself, just make sure you run them out 30 years to get the full picture.

Additional payments would cease after PMI is ended. I understand if the comparison is pay down mortgage or invest but this isn't the case. Why would I not use a fixed-term to calculate opportunity cost? At any rate it would look something like (a) Pay extra to mortgage until PMI is gone then invest in the market OR (b) invest in the market. Make comparison at 30 yr. This would favor the latter even more. [6% is a semi conservative real return that I use]And, in this scenario I am admittedly constraining the comparison to after-tax monies. Pre-tax would put the investment option over the top. But that is moot information regarding the decision making because even post-tax investments beat PMI (assuming you find my comparison adequate).

To get a true comparison, you have to go out 30 years, because if you pay off your PMI you'll 1) have more equity in the house and 2) the overall loan term would end sooner (freeing up those payments to other investments before 30 years). A shortcut to the calculations would be nice, but it doesn't work. That being said, without specifically running your numbers, I'm almost certain you'll be better off not paying extra on your mortgage.

I ran the math through the spreadsheet for your specific case, and it looks like with the assumption of 6% returns you're one of those that it is break-even between putting 20% down and getting PMI (both of which beat by a long shot paying down PMI after it is already had). Returns over 6% would favor PMI over paying 20% down, in your specific case.

Regarding Harry Hannah's comment: That is absolutely right, as you're paying PMI down you in theory approach an infinite interest rate right before you pay it off. I haven't done much research on when (or if) the optimal time to pay PMI off occurs.

To get a true comparison, you have to go out 30 years, because if you pay off your PMI you'll 1) have more equity in the house and 2) the overall loan term would end sooner (freeing up those payments to other investments before 30 years). A shortcut to the calculations would be nice, but it doesn't work. That being said, without specifically running your numbers, I'm almost certain you'll be better off not paying extra on your mortgage.

I failed to connect the dots. sometimes I need it explained like I'm 5.

it looks like with the assumption of 6% returns you're one of those that it is break-even between putting 20% down and getting PMI (both of which beat by a long shot paying down PMI after it is already had). Returns over 6% would favor PMI over paying 20% down, in your specific case.

it looks like with the assumption of 6% returns you're one of those that it is break-even between putting 20% down and getting PMI (both of which beat by a long shot paying down PMI after it is already had). Returns over 6% would favor PMI over paying 20% down, in your specific case.

By paying an extra $200 a month until PMI is gone, you would lose out ($141,011) over the life of the loan.By paying an extra $200 a month until the entire mortgage is gone, you would lose out ($237,014) over the life of the loan.

That is including inflation and still using an over-conservative 9.5% figure. Historically the S&P will do 10.5% to 11.5% with dividends reinvested, excluding inflation losses.

6% is WAY conservative.

Also, I did a 15% marginal total tax rate (state and federal, combined). Feel free to adjust it as needed.

I would say don't pay extra in to kill the PMI, instead research your options to remove PMI via appraisal and home-improvement. Be patient, and kill the PMI another way.(FYI - PMI of 0.3% is a fantastic PMI rate. It seems most are around 1% of cost of loan from what I've seen on here. )

Is PMI charged as a percentage of the mortgage balance or as a set dollar amount per month? Sorry, I've always put 20% down, so never paid it. If it's a set dollar amount, then the percentage rate increases at every monthly payment.